Hexagon Wealth



November, 2013
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Market Watch

In October, the Sensex rose by 9.2% - the best monthly gain since February 2012. The index also notched a new all-time high of 21,165. The rally was mainly driven by foreign institutional investors who poured in Rs 15,700 crores in Indian equities in October.

SENSEX -
                                        NOVEMBER 2013

SECTOR INDICES


The S&P BSE Bankex was the biggest gainer as banking stocks reacted positively to the cut in the MSF rate and to RBI’s decision to infuse liquidity. Better-than-expected earnings from key players such as ICICI also boosted sentiment.

The FMCG index was the only loser during the month. The stocks of FMCG companies may experience declines in the short-run as investors may book profits if earnings fail to justify high valuations. The long-term outlook for the sector is positive because rural penetration rates are relatively low but the sector may be plagued by high inflation and the consumption slowdown in the immediate future. This phenomenon was apparent in the latest earnings season as some FMCG majors reported a moderation in revenue growth.

FII_August

What does 21,000 actually mean?


On 31st October 2013, the Sensex rose to a record high of 21,165. The last time the index closed above 21,000 was on 5th November 2010.

However, as shown in the table, current valuations are more attractive than they were in 2010. The Sensex is currently trading at a P/E ratio of 18.27 – slightly above its long-term average. In spite of this, we are slightly cautious on equities as markets may be volatile in the run up to elections. We have advised some of our clients to reduce their exposure to equities because the recent rally has been supported by heavy foreign institutional investments (FII) rather than by strong fundamentals. GDP growth is stagnating at a ten-year low while inflation is sticky. Generally, sustainable rallies have been backed by earnings upgrades – these are not yet imminent.

Yields


The current rally has been fueled mainly by defensive large-cap stocks and is not supported by the broader market. The BSE Midcap Index is trading at a discount of about 40% to its peak. In January 2008, the index hit an all-time high of 10,113 but was only trading at 6,107 on 31st October 2013. Small & midcaps have lower price-earnings (P/E) ratios and hence have relatively more attractive valuations than their large-cap counterparts as shown in the table. The polarised valuations present a favourable opportunity for investors with risk appetites to initiate investments in small and midcap funds.

Cyclical stocks are also trading at cheap valuations. These stocks are generally the worst-hit in a slowdown as they are more sensitive to the fluctuations of the business cycle. Over the last few quarters, cyclical stocks have been adversely affected by the sluggish economy. Consequently, these stocks are now trading at more attractive valuations than FMCG, pharmaceutical, and IT companies. These stocks have been the biggest contributors to the rally this year as these companies have been largely immune to the slump in domestic growth.

The valuations of defensive and cyclical stocks may gradually converge as India’s economic outlook improves. Hence, the latter may start to outperform the broader market. In September, most of our recommended equity funds had a mix of cyclical and defensive stocks. Funds such as Birla Sun Life Dividend Yield Plus, HDFC Top 200 and HDFC Equity may generate higher returns for investors when the economy recovers as these funds had higher allocations towards cyclical stocks during the last few quarters.

How is India preparing for QE tapering?

In the second and third quarters of 2013, expectations that the Federal Reserve would taper its quantitative easing programme (QE) rattled global markets. However, investors have now pushed back their expectations of QE tapering as the U.S. government shutdown is expected to drag down growth. A premature end to the Fed’s stimulus may adversely affect the U.S. economy especially because another round of hostile negotiations over the debt ceiling in February may dent confidence. At an interactive session on 23rd October, Mr Tai Hui – the Chief Market Strategist for JPMorgan Funds Asia – stated that the Fed was unlikely to reduce its stimulus before March 2014.

A delay in QE tapering may provide a brief respite for India. Over the last few years, emerging markets such as India have benefited from the influx from global liquidity created through successive rounds of QE. However, between May and August, the rupee depreciated to a record low against the dollar as foreign institutional investors (FIIs) redeemed their holdings in emerging markets such as India after the specter of QE tapering spooked global markets. The delay in tapering has pushed up the rupee and postponed any potential reversal of FII flows.

Indian policymakers are implementing measures to mitigate the adverse affects of QE tapering by focusing on attracting additional capital flows. India is heavily dependent on foreign investment to fund its current account deficit (CAD).

An increase in foreign investment may limit the downside in the rupee when the Fed tapers QE. The pressure on the currency may also ease as the CAD is expected to decline in FY14 as the fall in the rupee may encourage exports and lower the trade deficit.

This may support growth and also reduce the country’s vulnerability to a decline in global liquidity which may occur when QE is tapered.


MEASURES
                                      TO ATTRACT FOREIGN INVESTMENTS

Furthermore, the RBI is now better positioned to support the rupee when tapering occurs as the central bank’s foreign exchange reserves have increased over the last few weeks. At the beginning of September, India’s forex reserves were worth only $274 billion but rose to nearly $283 billion in the week which ended on October 25.

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The RBI’s battle against inflation

In the second quarter monetary policy review, Dr Raghuram Rajan hiked the repo rate a second time to tame inflation.

The prices of short-term debt instruments may rise as yields are likely to fall as the RBI has reduced the MSF rate and infused liquidity. The rates on three-month and twelve-month certificates of deposits are already correcting. Hence, short-term funds may generate higher returns for investors. However, the prices of long-duration fixed income instruments may be volatile in the short-run as the near-term outlook for interest rates is uncertain.

REVIEW
INFLATION


The RBI may be forced to hike rates a third time if inflation does not come under control as the central bank believes it is important to control inflation to support savings and long-run economic growth.  The RBI expects WPI inflation to exceed current levels for the rest of the current fiscal while CPI inflation is projected to remain above 9%. Nevertheless, interest rates may decline in the medium-long term because of the economic slowdown which has not yet bottomed out.

In the first quarter of FY14, India’s GDP growth slipped to a four-year low of 4.4%. During the first five months of the fiscal year, the Index of Industrial Production (IIP) has only expanded by 0.1%. The latest PMI readings suggest that India’s services sector – which accounts for two-thirds of the country’s GDP – contracted in October. The silver lining is the robust monsoon which may support agricultural growth and restrict the rise in food prices.

Hence, further rate hikes may be limited. In the policy review, the RBI stated that it “will closely monitor inflation risk while being mindful of the evolving growth dynamics.” Consequently, long-term investors may eventually benefit from capital appreciation as interest rates must eventually fall. Investors with 3-5 year horizons can invest in long-duration funds in small doses as these funds will generate capital appreciation over the medium-long term when interest rates fall.

Are we saving enough?

A recent article in Economic Times suggests that even politicians are not immune from inflation. Politicians want a hike in the limits on election spending as they believe that rising prices have made campaigning more expensive.

TRENDS

Higher prices have also hurt savings. During the last decade, India’s high savings rate was one of the factors which propelled economic growth. But over the last few years, the country’s saving rate as a proportion of GDP has declined.

India’s savings rate (as a proportion of GDP) rose to a record high in 2007-08 but is projected to fall to 30% in the current fiscal year (RBI estimate). The decline can be attributed to the fall in financial savings which have slumped over the last few years as shown in the chart.

This trend suggests that Indians have shifted away from financial assets and are increasing using physical assets such as real estate and gold to save. This is disturbing as investments in gold and land are relatively unproductive and do not benefit the economy. In contrast, investments in financial assets can be used to fund investments and boost economic growth. The unpopularity of financial savings is mainly because inflation has eroded the returns on financial assets such as bank deposits and has depressed real interest rates. Real interest rates are adjusted for inflation and are calculated by subtracting the inflation rate from the interest rate.

Currently, real interest rates are in negative territory as consumer price inflation was 9.84% in September while the interest rates offered by leading private sector and public sector banks on one-year term deposits are only around 9% (pre-tax rate). This means that savers will not be able to beat inflation by investing in financial assets such as deposits. This factor influenced the RBI’s decision to hike rates as the Governor expressed concerns about the recent decline in savings in the monetary policy review. Although this may impair short-term growth, higher interest rates should push down inflation and boost savings as investors may earn higher real returns on financial instruments such as deposits.

The central bank also plans to launch CPI-linked bonds which will generate inflation-adjusted returns for investors. These bonds may help channelize more savings into financial assets. This may also increase savings and support long-run economic growth.

Sources:
Global Indices: Wall Street Journal
Domestic Indices: BSE/ Accord Fintech

FII/MF data: SEBI





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